Fundamental doubts over the dollar and the euro, the world’s leading reserve currencies, are pushing Asian central banks to prepare strategies to reduce reliance on western money.

Charting a new course: Cheng Ho’s fleet, seen here at a museum in Singapore, was commissioned to explore the seas of Asia. The region’s central banks are now on a similar quest for more local currency integration

The moves come in a variety of forms. The Asian countries – the 10 members of the Association of South East Asian Nations, or Asean, plus China, India and South Korea – are intensifying long-held plans for mutual monetary co-operation.

They are gradually allowing their own currencies to be used more widely in international reserve management. And their central banks are building up their own reserve holdings of each other’s currencies as part of an effort to reduce their considerable vulnerability to fluctuations in the dollar and euro.

The nervousness of Asian central banks about the dollar and euro is closely linked to the liquidity injections and quantitative easing measures taken by the US Federal Reserve and the European Central Bank to shore up economic activity in America and Europe.

Representatives of Asian central banks, as well as other leading emerging market nations such as Brazil, criticised western monetary policies at the annual meetings of the International Monetary Fund and the World Bank, which took place this month in Tokyo.

The charge is that low interest rates and plentiful liquidity in Europe and the US are inciting speculative investors around the world to borrow western currencies and place the proceeds in higher-yielding emerging market currencies.

These speculative inflows drive up exchange rates and worsen export prospects in Asia and Latin America, and also expose these countries to the threat of destabilising outflows once speculators tire of this particular version of the “carry trade” – borrow in low-yielding currencies and invest the money in high-yielding foreign exchange – and relocate their funds to other parts of the world.

Central banks in countries such as China, Indonesia, Malaysia, South Korea and Thailand are already practising mutual reserve holdings of their respective currencies.

Yi Gang, deputy governor of the People’s Bank of China, who is in charge of the State Administration of Foreign Exchange, which handles the county’s foreign reserves, confirmed in Tokyo that China had been accelerating currency diversification as a result of the dollar and euro problems. In addition to dollars, euros, yen and sterling, SAFE’s holdings are reliably understood to include Asean currencies.

The Reserve Bank of India, one of the most conservative central banks in Asia, has also been exploring strategic options for widening the number of currencies in its reserves. Asian central banks, led by China and Japan, account for the lion’s share of the world’s roughly $10 trillion foreign exchange reserves, which have grown tenfold over the past 20 years.

According to the IMF, slightly more than 60% of world reserves are in dollars, with 25% in the euro. The rest is placed in a wide variety of currencies including relatively minor units such as Australian, Canadian and Singapore dollars and some Scandinavian currencies.

-- Single currency

The Asians have been considering vague plans over the past decade to introduce some form of single currency. Support for this idea has collapsed as a result of the difficulties encountered by economic and monetary union in Europe.

When the euro was established 14 years ago, many Asian central banks saw the new arrival as a signal that they would no longer have to rely solely on the dollar.

Yet, hopes that the euro would emerge as a stabilising dollar counterweight have proven short-lived. So Asia is now attempting to develop long-term policy alternatives. This is part of a long-term trend, sparked partly by efforts to improve common Asian policies in the economic and monetary sphere after the Asian financial crisis of 1997-1998.

For years, the Asians have been trying to increase common ground in areas such as financial market integration, banking supervision and mutual credit mechanisms and swap lines. The travails of the dollar and euro have lent impetus to these moves.

Since the 1950s, Asia saw Europe as an integration model. Now they are not so sure. As a senior Asian central bank official puts it: “We always thought the Europeans had better systems and better people. Now we doubt whether this is so.”

Prasarn Trairatvorakul, governor of the Bank of Thailand, summed up the Europeans’ relative position in London on September 12. The south-east Asian countries recovered relatively quickly after the Asian financial crisis, regaining competitiveness through rapid depreciation and general economic policy flexibility. “However, this flexibility is not practical for Europe, given its single currency setting and attendant political complexities.”

Asia’s vulnerability to today’s currency constellation is highlighted by the potential for large losses on Asian currency reserves. Asian central banks invest, above all, in low-interest government securities denominated in the dollar and the euro, which themselves have been depreciating against many Asian currencies. The central banks’ liabilities, on the other hand, are primarily denominated in the state’s own currency, where interest rates are much higher.

This glaring currency and interest rate mismatch is exposing some leading Asian central banks to the politically sensitive requirement of seeking substantial government injections to help plug balance sheet losses.

Long term, there are only really two ways to resolve this dilemma. Either a sharp reduction in these countries’ foreign exchange reserves, which can come only in the wake of better world economic balance and will probably take years to achieve. Or the development of alternative assets, primarily through purchases of Asian foreign currencies.

Although these markets are still small and relatively illiquid, this trend is bound to continue. According to China’s Yi Gang, this will be a market-orientated process under which the world’s investors and traders seek alternatives to the dollar and the euro.

Asian governments will do their best to encourage this development. It may take five to 10 years to come to fruition. But the contours of a more integrated Asian economic and currency area are becoming ever more apparent.

-- David Marsh is chairman of think tank Official Monetary and Financial Institutions Forum and author of The Euro – The Battle for the New Global Currency (Yale University Press)